Brazil’s Credit Rating at Risk Unless Dilma Rousseff Embraces Reform

With the real weakening despite central bank’s rate hike, analysts look to appointment of a new finance minister to signal Rousseff’s direction in second term.

Rousseff Takes Lead in MDA Poll With Brazil's Election Days Away

Candidate Dilma Rousseff, Brazil’s president, speaks during a news conference at a campaign event in Rio de Janeiro, Brazil, on Tuesday, Sept. 30, 2014. Rousseff has pulled out ahead and would win next month’s election against former Environment Minister Marina Silva in an MDA poll. Photographer: Dado Galdieri/Bloomberg *** Local Caption *** Dilma Rousseff

Dado Galdieri/Bloomberg

Brazil is on course to lose its coveted investment-grade credit rating unless the re-elected president, Dilma Rousseff, changes course and embarks on major economic reform, analysts say.

“Brazil is now trapped in a stagflation equilibrium with high inflation and with three of the last four quarters posting negative economic growth,” says Alberto Ramos, New York–based head of Latin America economic research at Goldman Sachs Group. “I cannot see the government dramatically changing its economic policy during the second term. It might make a few adjustments on the monetary and fiscal sides, but this will not be enough to restore market confidence.”

Financial markets were quick to register their disappointment with voters’ decision to return Rousseff to the presidency, with the real coming under pressure and Brazilian stock prices falling immediately after the October 26 election. Banco Central do Brasil helped steady markets with a surprise 25 basis point hike in its policy rate, to 11.25 percent, on October 29. Analysts welcomed the move. Rousseff had argued against the need for a rate hike during the campaign, and the central bank’s quick action demonstrated real inflation-fighting resolve, analysts say.

“The central bank’s recent rate hike indicates that it has real autonomy,” says Bruno Rovai, New York–based Brazil economist at Barclays. “Brazil is different from some other Latin American countries because it has very strong institutions, not only the central bank but also the electoral courts, the supreme court and the Congress.”

Yet Brazilian asset prices remain weak. The real was trading at 2.5374 to the dollar on Monday, off from 2.49 on the eve of the election and down nearly 12 percent since the start of June. The São Paulo Stock Exchange’s IBOVESPA index was trading around 53,600 on Monday, up 4.1 percent for the year to date but down more than 13 percent from its high for the year in early September, when a surge of support for opposition candidate Marina Silva was fanning hopes of a change in leadership. (Silva was eliminated in the first round of voting in early October.)

The country’s economic numbers are deteriorating. Brazil entered a technical recession during the second quarter, and most economists believe output has continued to decline in the second half. The country’s 12-month rolling consumer price inflation rate is currently around 6.5 percent, at the top end of the central bank’s target range of 4.5 percent plus or minus 2 percentage points. The trade deficit hit $1.17 billion in October, the highest since?? 1998.


The fiscal situation has also worsened. In September the public sector posted a much wider than expected primary deficit (which excludes debt-servicing costs) of 25.5 billion reais ($10.1 billion). Over the 12 months to the end of September, the consolidated public sector primary fiscal surplus slipped to 0.61 percent of gross domestic product, substantially below the government’s target of 1.9 percent. This year the country faces its first annual primary deficit in almost two decades. The twin fiscal and current-account deficits are now tracking at a combined 8.6 percent of GDP, the worst picture in almost 15 years.

Market participants are eagerly awaiting the appointment of a new finance minister to replace Guido Mantega, an incumbent and Rousseff loyalist who analysts say damaged the government’s credibility with loose fiscal policy and overly optimistic economic forecasts. Analysts expect Rousseff to choose a nominee this month from a short list that includes Nelson Barbosa, former deputy finance minister; Alexandre Tombini, the central bank president; and Luciano Coutinho, president of the powerful National Bank for Economic and Social Development (BNDES).

Analysts say an appointment of Barbosa could send a welcome signal of fiscal discipline. Barbosa was deputy finance minister from 2011 to 2013 but resigned, apparently because of differences with Mantega and with Treasury Secretary Arno Augustin over alleged creative accounting to meet the government’s fiscal targets.

Tombini, who has led the central bank since 2011, was initially viewed as dovish on monetary policy but spearheaded the rate rise last month to contain mounting inflationary pressures. Coutinho leads an agency that has grown substantially since the 2008–’09 financial crisis; BNDES extended 190 billion reais in credit in 2013, one third more than the World Bank. Analysts regard him as someone who is committed to state intervention in the economy.

Analysts question how much room to maneuver the new finance minister will have, given Rousseff’s penchant for micromanaging economic policy. “Dilma was very closely involved in economic management during her first term,” says Barclays’s Rovai. “Only political reforms seem to be on her current agenda — no reforms of microeconomic policy, for example. I do not see any meaningful changes to the government’s economic approach taking place. There might be more reliable fiscal numbers, but that is about it.”

Under former president Luiz Ignácio Lula da Silva, Brazil enjoyed its best economic performance in a generation as growth averaged about 4 percent a year. Although Brazil benefited from a massive terms of trade boost, thanks to booming exports of commodities such as soybeans and iron ore, analysts gave Lula credit for promoting consumption with income support for poorer Brazilians while giving the private sector considerable leeway.

During Rousseff’s first term, growth slowed to an average of about 1.6 percent a year, a weaker performance than all but two presidential administrations since Brazil became a republic in 1889. In September the government cut its growth forecast for this year to 0.9 percent from 1.8 percent previously, but most private economists predict the growth rate will be barely positive for the year, given the decline in the first half.

The president has championed state involvement in the economy and meddled in the affairs of state-controlled enterprises such as Petroleo Brasileiro, the oil giant. During Rousseff’s first term, Petrobras, as the company is known, had $44 billion in operating losses, mainly from being forced by the government to sell fuel at below-market prices. Rousseff is a former energy minister who served as chair of the Petrobras board prior to assuming the presidency.

Allegations of corruption at Petrobras dogged Rousseff during the election campaign. A former executive, Paulo Roberto Costa, who was arrested in March on money-laundering charges, told prosecutors that an alleged kickback scheme diverted money from Petrobras contracts to politicians, mainly members of Rousseff’s Workers’ Party, according to Brazilian press reports. Petrobras has delayed the release of its third-quarter earnings after its auditor, PricewaterhouseCoopers, declined to sign off on the results due to the corruption allegations, according to the newspaper O Estado de S. Paulo.

Under the Workers’ Party of Rousseff and Lula, which has been in power since 2003, the country’s overall tax burden has risen from 32.6 percent of gross domestic product to 36.4 percent.

Arminio Fraga, who was central bank president from 1999 to 2002 and drafted the economic platform of Aécio Neves, the centrist presidential candidate of the Brazilian Social Democracy Party whom Rousseff defeated in the October 26 runoff election, argues that the country’s economy can be fixed only by restoring credibility to the budget and by bringing inflation down to the long-term target of 4.5 percent. Fraga, who is co-CIO of Gávea Investimentos, a Brazilian hedge fund firm owned by JPMorgan Chase & Co., had promised to reform the country’s tax system if Neves won and appointed him finance minister, by introducing a national value-added tax and by removing taxes on exports and investments.

Brazil is not in immediate danger of losing its hard-won investment-grade status — which it has enjoyed since 2008 — but it could face a downgrade in 2015 if Rousseff doesn’t change tack.

In March Standard & Poor’s downgraded Brazil’s foreign currency rating to BBB−, the lowest investment-grade rating. “We downgraded the sovereign because of the lack of transparency on the fiscal side,” says Lisa Schineller, managing director, Latin America sovereigns at S&P. “All the maneuvering weakened macro credibility. We felt that the weak fiscal situation was likely to continue. What happens next depends on whether public debt continues to rise, the signals that the government gives the markets and the overall execution of economic policy.”

In September Moody’s lowered its outlook on Brazil’s Baa2 rating, two notches above speculative grade, to negative from stable. “The numbers coming out of Brazil this year have been much worse than expected,” says Mauro Leos, manager of the Latin America sovereign risk group at Moody’s. “The next administration will encounter an economy in pretty dire economic straits. The worsening debt-to-GDP figures justify why the markets are concerned that Brazil could lose investment-grade. That would be a big deal for the country.”

“Brazil has disappointed during the last four years,” adds Leos. “Investors can handle one bad year, but they have a much greater problem with four consecutive poor years.”

Gross general government debt rose to 61.7 percent of GDP in September from 56.7 percent and 53.4 percent of GDP in 2010. It rose above the 60 percent level on two previous occasions during the past 12 years, in 2002 and 2009, but quickly fell below the threshold as growth accelerated. “The concern is that the debt level will continue rising this time round,” says Leos. “We will decide next year whether or not we have to change the credit rating.”

Brazil’s situation is so precarious that some analysts believe it may force a change of policy by Rousseff. As yet, however, there are no real signs of that happening.

“In my view, Brazil is on a knife edge,” says Goldman Sachs’s Ramos. “I think it will surprise in either a very positive way or a very negative one.”